Understanding Convertible Debt and How it Affects Your Cap Table
Convertible debt (also referred to as debt notes or bridge notes) has become an increasingly popular way for early-stage companies to raise money. However, many founders do not fully understand how these equity derivatives can impact their cap table. In this article, we’re going to break down what convertible debt is, how it works, and how it can impact your cap table and business.
Raising Capital With Debt or Equity
First, let’s start with a quick refresher on the two mechanisms through which most private companies can raise capital: debt and equity. A startup can raise debt or equity to finance their business and while both involve an exchange of money between two parties, the key difference is how that money is repaid.
When a startup raises debt, it must repay that debt in full at the maturity date and usually with interest. With equity, however, capital is received with expectation that the equity holder will only receive a return on their investment when the company has a liquidity event or successful exit.
The challenge with issuing equity as an early stage startup is that founders and investors must agree on the value of the company. Coming to an exact valuation can be very difficult - an early stage startup often has no revenue, little to no customers, and very few other indicators of value. At the same time, preferred equity may carry certain rights or liquidation preferences that founders may not want to give up in the early years of the business.
But companies also have an alternative option which combines debt and equity via an instrument called convertible debt.
Understanding Convertible Debt
Like a loan, a convertible note has a date of issuance, interest rate, and a maturity date. But rather than repayment with cash, convertible notes are typically repaid with equity. A certain number of shares are given to the note holder as repayment, usually based on three factors:
1. The outstanding balance on the note
2. The value of the company upon repayment
3. The number of shares that are currently issued and outstanding
Convertible notes can also have what are called conversion caps or conversion discounts. A conversion cap sets a maximum valuation for the company at which the debt will convert into equity (e.g., $1,500,000). However, if the company’s actual valuation at the time of financing is lower than the conversion cap, the debt converts at the company’s actual valuation.
A conversion discount specifies a discount rate that is applied to the company’s valuation for purposes of calculating a conversion price. This is typically expressed as a percentage (e.g. 20%). For example, if the company’s valuation is $2,000,000 and the discount is 20%, then the debt will convert at a valuation of $1,600,000.
While convertible notes don’t have to specify a conversion cap or a conversion discount, it’s not uncommon for them to include one or both. In any case, the debt will usually convert at the valuation that is most economically advantageous for the note holder.
The Mechanics of Conversion (Conversion Price Formula)
Perhaps the best way to illustrate how convertible debt works is to look at a practical example. For this, we’re going to take a sample cap table and convertible debt agreement and break down how the conversion would happen and what the impact to the company would be.
Below we have a cap table with three founders, each of whom own 300,000 shares. An additional 100,000 shares have been set aside in an option pool for future hires, for a total of 1 million shares. The cap table is fully-diluted, meaning it includes the shares that have been set aside by the board for issuance (generally in the form of options) but have not yet been issued. (We’ll get to why that is important later).
HYPOTHETICAL EXAMPLE – For illustrative purposes only above or immediately below the various scenarios.
Let’s say the company issues convertible notes with conversion caps and no conversion discounts to two venture capital firms:
The company now seeks to raise Seed Round financing: $500,000 of additional capital at a pre-money valuation of $3,000,000. They will also convert the debt into the seed round as part of the transaction.
So how many shares does everyone get? The first step to answering this question is finding the share price paid by each investor.
This is easy enough to do. The new investors agree that the company is worth $3,000,000. Looking at the fully-diluted cap table, we see that there are 1 million shares outstanding. We divide the pre-money valuation by the fully-diluted number of shares to find the price per share of the Seed Round:
$3,000,000 / 1,000,000 = $3 per share
The new investors are investing $500,000, so they will receive 166,667 shares of preferred stock:
$500,000/ / $3 per share = 166,667 shares
The debtholders, however, do not pay $3 per a share for their preferred stock. Both debtholders negotiated for a conversion cap when they invested – Anderson Capital at a $1,000,000 cap and Schuller Ventures at a $1,500,000 cap. Therefore, Anderson Capital will convert to equity at $1 per a share:
$1,000,000 / 1,000,000 shares = $1 per share
Schuller Ventures will convert over at $1.50 a share:
$1,500,000 / 1,000,000 shares = $1.5 per share
At these share prices, Anderson Capital will receive 250,000 shares of Series Seed stock and Schuller Ventures will receive 166,667 shares. The company’s cap table now has a total of 1,583,334 shares:
The founders have been diluted down from 30% each to 18.95% each. Also take note that although Anderson Capital and Schuller Ventures each invested the same amount of money, Anderson Capital has more shares. This is because they negotiated for a lower conversion cap than Schuller Ventures.
Similarly, Schuller Ventures has the same number of shares as the “new investor”, although they only invested half as much money. Again, this is because of the $1,500,000 conversion cap.
In the example above, both debtholders held notes with conversion caps. The math with a conversion discount is not very different. If the terms of a convertible note specify a 20% discount, and the price per share paid by the new investors is $3, then the note holder would convert to equity at a share price of $2.40. A convertible note with an outstanding balance of $250,000 would convert into 104,167 shares.
When to Convert into Equity?
One question left unanswered from the above scenario is: how should the company determine when the debt should turn to equity? The ideal time to convert will often depend on the company’s growth and when the first round is raised. Sometimes it may come down to the terms specified in the legal documents.
Realizing that the timing is unique to each situation, there is one rule that founders and investors should both know: converting debt before the next round is raised will dilute the founders more than if the debt had been converted as part of the next round.
Let’s go back to the original example and do the conversion as if it happened over two funding rounds instead of one. First, let us convert the notes (at $1 a share for Anderson Capital and $1.50 a share for Schuller Ventures). The cap table is now as follows:
The new investor then invests the same $500,000 at the same $3,000,000 pre. Again, the price per share is calculated by dividing the $3,000,000 valuation by the number of fully-diluted shares:
$3,000,000 / 1,416,667 shares = $2.12 per share
Now the price per a share the new investor pays is $2.12 instead of $3! The lower share price is because the debt converted before the round and there are now more shares on the cap table. With a lower share price, the new investor receives more shares and this leads to even greater dilution to the founders than in the original scenario.
$500,000 / $2.12 per share = 236,072 shares
In the previous conversion scenario, the founders each owned 18.95% of the company, but by converting in two rounds instead of one, the founders are diluted down to 18.15%. The difference may seem insignificant; but compare the difference for the new investor. Before, the new investor had 10.53% of the cap table – now it’s 14.28%!
There is no fundamental change in the valuation of the company (it’s still $500,000 at a $3,000,000 pre); but switching up how things convert drastically affects the cap table.
In total, including the option pool, the founders give up an additional 2.67% of the cap table. That is enough equity for two or three key hires.
The Fully Diluted Cap Table
Let’s return for a moment to the concept of a fully-diluted cap table.
Going back to our example, the company has actually only issued 900,000 shares, but because we’re looking at a fully-diluted cap table, the 100,000 shares set aside in the equity plan for issuance were included in the calculation. Why? These shares are treated as issued because there is a real intent to issue them.
Investors generally force founders to set aside an option pool before investing in them. They don’t like investing in a company only to get diluted upon the hiring of a CFO, CTO, or other officer.
Understanding this concept, some founders become overzealous and want to include ALL authorized shares in the fully-diluted cap table. However, this is a mistake for three reasons:
- Just because shares are authorized does not mean there is real intent to issue them. The authorized share count simply represents the number of shares authorized to be issued according to the company’s certificate of incorporation. (Or to put another way – just because you can issue them, it doesn’t mean you necessarily will issue them.)
- If or when you do decide to issue more shares in the future, your new investors will get a say in things. They are willing to be diluted under the right circumstances (the raising of a future round). Options, however, are generally granted out of the option pool without any input from the investors, so they just want to know what the dilution looks like up front.
- The authorized number for common stock is large enough to facilitate the conversion of all preferred securities into common stock. If all the authorized shares were considered in the fully-diluted cap table, the preferred shares would be double-counted.
Pre-Money vs. Post-Money Valuation
Another important concept to call out with convertible debt is pre- versus post-money valuation. This refers to the valuation of the company before or after new capital is invested.
In the example used above, the pre-money valuation was $3,000,000. This meant that each of the company’s existing 1 million shares was worth $3. After the new investors added $500,000 to the company’s books, the company instantly increases in value by $500,000. So $3,500,000 is the post-money valuation.
In other words, the post-money valuation is simply the value of the company after the new investment round. Investing $500,000 at $3,000,000 pre is the same thing as investing $500,000 at a $3,500,000 post.
When calculating the price per share of the new round given the fully-diluted number of shares, one should use the pre-money and not the post-money valuation.
The Problems With Convertible Debt
Convertible debt is a flexible instrument in situations where companies and investors cannot agree on a valuation. However, convertible debt is still debt. This means that convertible notes will typically accrue interest (usually between 5-10%) which the company is responsible for.
Convertible debt is also a considerable balance sheet liability for a young startup. The prospect of having to pay that money back at a fixed date may not be ideal for a company that is still in growth mode.
Finally, as the above scenario illustrates, the inner workings of convertible debt can get complex very quickly.
Convertible debt can be an advantageous financing method for young startups; but also, one that creates potential administrative challenges down the road. Convertible debt can significantly impact your future cap table, which is an essential part of your private company’s growth strategy. Before issuing convertible debt, it is critical that you consult the legal and financial parties to assess how to structure it in a way that best support your company’s long-term growth.
And of course, don’t hesitate to reach out to Shareworks if you want to learn more about how convertible debt can impact your cap table.